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December 19, 2012

Prudential Case Study Weighs Impact of Risk on Retirement Outcomes

Consumers buy insurance for their homes, cars–why not retirement? Prudential demonstrated in a white paper released Monday what could happen to investors’ retirement prospects if they didn’t plan for the various risks that could affect their income.

Investors’ abilities to work and generate income are assets that should not go overlooked, Prudential said in the paper. Even though the chance of premature death or a disability that prevents an individual from working is small, the consequences are “significant.” Life and disability insurance protect against those consequences.

“Life insurance helps families manage the risks of not living as long as expected, while guaranteed retirement income products help Americans manage the risk of outliving savings in retirement,” Bob O’Donnell, president of Prudential Annuities, said in a statement.

After retirement though, when income is generated not through an investor’s ability to work but their investments and savings, they face risk from longevity, uncertainty and sustained low interest rates. According to the paper, for a 65-year-old married couple there is a 50% chance that one of them will live to 94.

“While the majority of Americans insure their most valuable assets in order to safeguard against significant financial loss, many don’t think to insure their ability to generate lifetime income,” O’Donnell said. “Today’s guaranteed income products were designed to help protect retirees from running out of income in retirement, regardless of market conditions or increased longevity.”

To examine the impact of those risks on retirement, Prudential performed a case study using data from Ernst & Young’s insurance and actuarial advisory services practice and retirement analytics model.

“Jean” is a 65-year-old woman with $300,000 in financial assets and no future retirement income protection. The portfolio has a typical 60/40 equity bond mix and an investment management fee of 1%. She will take annual distributions of $15,000 to supplement her Social Security benefits.

Prudential ran three scenarios for Jean’s portfolio, first looking at an environment with no market volatility or longevity risk. Prudential assumed an 8% investment return for each year of Jean’s retirement, which lasted until the end of her life expectancy at age 90.

Unsurprisingly, Jean’s portfolio lasted her lifetime under those ideal conditions, as her 7% net return (the investment return minus management fees) exceeded the 5% of her portfolio she was withdrawing. Importantly, her principal remained intact and increased each year, according to the paper.

However, adding market volatility and longevity risk to the second scenario increased her chances of running out of income to 21%. Prudential noted that an 8% return every year is unrealistic, and Jean could easily live longer or die earlier than her life expectancy says she will.

In scenario three, where a long period of low interest rates is added to the factors in scenario two, Jean’s failure rate jumps to 54%. Citing Japan’s two-decade interest rate low as precedent, Prudential assumed U.S. rates would stay at their Dec. 31, 2011 level throughout Jean’s retirement.

Those scenarios resulted in significant shortfalls in Jean’s retirement income. In scenario two, Jean ran out of income in 420 out of 2,000 simulations; the average shortfall for those 420 outcomes was over $158,000–that’s over 10 years without the additional $15,000 she expected to supplement Social Security benefits, according to the paper. In the worst 10% of the simulations, the average shortfall was nearly $257,000, or 17 years without additional income. Looking at scenario three is even more alarming.

Of the 1,080 simulations where Jean ran out of income, the average shortfall was over $161,000. The average for the worst 10% of simulations was $348,000. According to the paper, that equates to 23 years without additional income to supplement Social Security.